1. Field of the Invention
The present invention relates generally to asset securitization and, more particularly, to a system and method for use in securitizing a portfolio of at least 30% (and up to 100%) distressed commercial credit facilities, such that all of the securities above the equity or equity-like tranches issued by a bankruptcy-remote special purpose entity to finance the acquisition of the portfolio of distressed commercial credit facilities are eligible to receive investment grade ratings.
2. Description of the Prior Art
A credit facility is considered “distressed” if the borrower's financial ability to honor its obligations comes into question. Common indicators that a borrower (or group of related borrowers, hereafter referred to collectively as the “borrower”) may have financial difficulty in repaying its debt include a breach of financial covenants, a payment or technical default of other debt obligations, or a trading value for the borrower's debt significantly lower than other debt with similar coupon and maturity features. Not all distressed credit facilities are in default (e.g., as recognized by Standard & Poor's (“S&P”), a company may be current on its bank loan obligations while being in technical or financial default on its other subordinated debt, resulting in significant near-term risk that the borrower will ultimately default on its obligations) (Albulescu, Henry, Bergman, Sten, and Leung, Corwin, “Distressed Debt CDOs: Spinning Straw Into Gold,” S&P Structured Finance, May 7, 2001, hereafter, “Spinning Straw Into Gold”). As used herein, “distressed credit facilities” and “distressed loans” are those commercial loans in which there has been a default by a borrower to make a payment or payments to a lender and/or a likelihood of a default has been identified by a lender in connection with the borrower's obligation to make a payment to the lender.
Distressed loans are known to be subject to increased monitoring and may be subject to special accounting treatment. If a lender is a bank or other regulated entity, such distressed assets may subject the lender to increased capital requirements and regulatory scrutiny.
Lenders previously have had a limited number of alternatives for dealing with distressed credit facilities. One alternative is for the lender to continue to hold its distressed credit facilities. This option, however, imposes a number of additional costs on the lender. For example, a lender who retains distressed assets may need to employ specialized personnel and/or commit other management resources to manage and handle work-outs of the distressed loans, and establish appropriate reserves for loss contingencies. The process of working with problem borrowers to recover on distressed credit facilities is time-intensive and requires special skills and resources of a lender, often not readily or plentifully available to the lender on a cost-effective basis. If the lender is a bank or similarly regulated entity, the lender may need to establish reserves to ensure the lender's compliance with applicable regulatory requirements. Retaining distressed assets may further risk giving interested third parties, such as regulators, stockholders and financial analysts, a negative perception of the lender's portfolio quality and management acumen, and may expose the lender to potential further loss if a distressed borrower's creditworthiness continues to deteriorate. In addition, in the case of revolving loans where a lender has approved a line-of-credit for a borrower, the lender may have a contingent obligation to lend additional monies to an already faltering borrower.
Another alternative traditionally available to the lender is to sell a distressed credit facility to “vulture” investors at a cash price representing a significant discount to the outstanding principal. This alternative may eliminate applicable regulatory pressure on the lender caused by the presence of the distressed credit facility on the lender's financial statements and may also eliminate the lender's risk of future losses from the credit facility. However, it is a costly remedy because of the immediate and likely steep losses that the lender incurs as a result of the sale at a discount.
Traditionally, there has been little market for a “one-by-one” sale of distressed credit facilities; to the extent such a market has existed, it has been characterized by punitive pricing and illiquidity. Middle-market syndicated loans (i.e., aggregate credit facilities of less than $100 million, for example, with five or fewer lenders participating in any of the credit facilities) and single-lender facilities often can be sold only to predatory investors in bulk-loan sales at substantial discounts, again resulting in steep losses to the lender. Loan losses from such sales not only have obvious economic repercussions, but also generally have unfavorable effects on the financial institution from the perception of interested third parties (e.g., regulators, investors and financial analysts) who may interpret the loan losses as an indication that the lender's assets generally are of poor quality and that the management of the lender is imprudent or incompetent. As a result, lenders, hoping to minimize their losses, often resort to the liquidation of borrowers with distressed credit facilities at much reduced recoveries.
Each of these options has a number of significant disadvantages for a lender. Consequently, lenders historically have been forced to weigh distasteful alternatives with a goal of developing a strategy for handling distressed credit facilities that a lender believes to be the least onerous. Because virtually any portfolio of outstanding credit facilities is likely to include some distressed credit facilities, lenders almost invariably are required to devote substantial time and capital to developing and implementing acceptable strategies for handling their distressed credit facilities.
Securitization of distressed credit facilities has previously generally been unavailable as an alternative for lenders. In a traditional securitization of commercial or corporate credit facilities and/or high yield loans, a portfolio of generally performing credit facilities, characterized generally by regular cash flows and predictable recoveries, is sold by a lender or lenders to a bankruptcy-remote special purpose entity (an “SPE,” e.g., a bankruptcy-remote special purpose trust, corporation or limited liability company) that finances the purchase by issuing asset-backed securities, (e.g., notes or bonds) and equity and/or equity-like securities to its investors. “Bankruptcy remote”, as used herein, has the meaning common in securitization transactions of an entity which, due to governance provisions in its organizational documents, agreements with equity owners and creditors, or other measures, is less likely to be subject to a petition in bankruptcy than a normal operating company. The underlying pool of generally performing credit facilities is used to secure or collateralize the asset-backed securities issued to investors in the SPE and/or to the lender or lenders from whom the credit facility pool is acquired. Heretofore, securitizations of commercial credit facilities or high yield bonds have been comprised principally of relatively high quality collateral with predictable and scheduled interest and principal payments, thus assuring predictable and regular cash flows and recoveries. The asset-backed senior and mezzanine debt instruments issued by the SPE in a securitization of such commercial credit facilities or high yield bonds are known to have received investment grade ratings (e.g., ratings of Baa2/BBB−, or better) from credit rating agencies (e.g. S&P, Moody's Investor Services (“Moody's”) and Fitch, Inc. (“Fitch”)) based upon the predictable, regular stream of cash flows (i.e., interim payments of interest and principal) and the predictable recoveries (i.e., actual aggregate payouts of interest and principal) generated by the underlying debt asset pool, resulting in a high degree of certainty that the SPE can meet in a timely manner all of its debt service obligations, including principal and interest. The achievement of such investment grade ratings for the asset-backed senior and mezzanine debt securities issued by the SPE allows the SPE to finance the acquisition of the credit facility portfolio on a cost-effective basis (investment grade securities generally bearing a significantly lower interest rate than non-investment grade securities and generally being more easily sold in the marketplace).
On the other hand, portfolios which include, for example, 30% or more of distressed commercial credit facilities previously have been characterized by the unpredictability and irregularity of their cash flows (sometimes referred to as “lumpiness”) and recoveries resulting from the low quality of the distressed debt assets comprising a substantial portion of (or all) the portfolio. Prior to the present invention, this unpredictability and irregularity of cash flows and recoveries has precluded lenders from securitizing such a portfolio of distressed credit facilities on a cost effective basis, because of the inability to obtain all investment grade ratings for the asset-backed debt securities issued above the equity or equity-like tranche or tranches and used to finance the acquisition of the distressed credit facility portfolio. As used herein, the phrases “equity or equity-like tranche or tranches,” “equity or equity-like tranches,” “equity or equity-like instruments,” “equity or equity-like securities” or words to similar effect include, for example, non-investment grade payment-in-kind (PIK) securities, securities whose tax characterization is uncertain, securities without a capped return, and securities that have a yield that is not commensurate with having an investment grade rating. Without the ability to obtain investment grade ratings, it was impractical for a lender to securitize a portfolio of distressed commercial credit facilities because it would be too costly to support the interest cost of the asset-backed debt instruments issued in the securitization above the equity or equity-like instruments issued (investment grade securities generally bearing a significantly lower interest rate than non-investment grade securities).
Credit rating agency ratings for asset-backed securities are determined based on various parameters including cash flow modeling of the proposed transaction, stressing defaults and their timing, recovery rates and their timing, and liquidity needs. However, while the fundamentals of the rating process remain the same, the analytical emphasis and the assumptions used for rating a portfolio of 30% or more distressed credit facilities differ in response to the specific characteristics of distressed debt. (See, “Spinning Straw Into Gold.”) For example, a typical SPE involved in a securitization of performing commercial credit facilities is stressed by a credit rating agency based on defaults and their timing. However, for an SPE whose underlying assets include 30% or more of distressed commercial credit facilities, a substantial portion of the loans in the pool are either already defaulted or expected to default. Thus, stressing defaults as a principal focus would not properly demonstrate the likely performance of the portfolio. Rather, recoveries, which are the primary driver of performance in a portfolio of distressed commercial credit facilities, are also stressed with the level of stress depending upon the credit rating sought.
Prior to the present invention, there has not been a system and method to achieve all investment grade ratings for the asset-backed securities above the equity or equity-like instruments an SPE issues to its investors and/or the lender or lenders as part of the purchase price for the portfolio of distressed commercial credit facilities, and thus there has not been a system or method to achieve pricing for the securitization of a portfolio of 30% or more distressed credit facilities comparable to that of a securitization of a performing loan pool. Investment grade ratings for the asset-backed securities issued by a distressed debt SPE result in a low cost of capital for the SPE, which allows the SPE the time to achieve the necessary recoveries on the underlying distressed assets and allows for ease of placement of the SPE's asset-backed securities in the marketplace in a manner and at prices comparable to those of SPEs whose underlying assets are performing commercial credit facilities or high yield bonds. Thus, there is a need for a method for securitizing a portfolio which includes, for example, at least 30% or more of distressed commercial credit facilities on an efficient cost-effective basis.